Relationship between foreign exchange rate and central bank rate

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Abstract

Central Bank of Kenya (CBK)’s principal objective is formulation and implementation of
monetary policy directed at achieving and maintaining stability in the general level of
prices which includes the exchange rate. Monetary policy rests on the relationship
between rates of interest in an economy. In Kenya the Central Bank’s role is to set a
short-term official rate of interest called the Central bank rate (CBR). The CBR serves as
a signaling tool on the direction on which monetary policy is taking. This study aimed to
establish if there is any relationship between Foreign Exchange rate and Central Bank
rates (CBR) in Kenya. This study adopted explanatory research design. The target
population of the study was time series data for Kenya on KES/USD Foreign exchange
rate and CBR. Monthly nominal data was used for the period from the month of June
2006 to August 2013.
Secondary data was collected electronically from the Central Bank of Kenya data base.
Data was analyzed using statistical software Strata version 7 and Excel. The findings of
the study showed central bank rates for the period of study have a weak positive
relationship to the foreign exchange rate and hence have no much effect on the exchange
rates. The CBR was thus found not to be an effective tool for exchange rate
determination. In view of this, the study recommends the monetary policy committee
devises a mechanism in which the CBR can be a signal to both the domestic and
exchange rate market.